POSTJUDICE

Monday, March 17, 2014

Westerners are still in disbelief that what is unfolding on their TV and internet screens is happening in the real. Is it really about Mr Putin securing personal access to his beloved Harley Davidson rallies in Crimea? Or is it about shoring up domestic support in the wake of reduced dollar liquidity in the emerging markets, including Russia? Analysts have to be excused for feeling a bit of cognitive dissonance because not even knowledge of (and understanding for) Russia’s deep geostrategic insecurity can palliate the stark inconsistencies in the Kremlin’s argumentation:

1. The move to annex Crimea (and threats to other parts of Ukraine) has been undertaken ostensibly to ‘protect’ Russian speakers abroad. This neocolonial project sets the bar very high for other ex-empires. What will Spain do to protect Spanish speakers abroad? And Saudi Arabia? Should Turkey invade Xinjiang in China, just because the Turks trace their origins to central Asia? Or should the State of Ukraine now invade Krasnodar or Stavropol in Russia because significant numbers of Ukrainians live there?

2. The move has been justified by alleged parallels in history – from the predictable (Kosovo) to the abstruse (Mayotte). A diplomat as astute and intelligent as Lavrov sounded quite desperate throwing this last argument on the table (my French friends went, like, ”il parle de quoi, déjà?”). But if those various historical parallels did, indeed constitute geostrategic mistakes of the said nations, then why is Russia today emulating the West’s errors by taking over a part of a territory belonging to a foreign state?

3. It is possible that beyond the choreographed nationalistic amok, there is some commercial interest – not so much in Crimea proper, whose budget was always subsidized by Kiyv, but in the adjacent waters, which could contain significant hydrocarbon resources. But Russia’s economy is already over-dependent on hydrocarbons and success in resource identification is not concomitant to success in marketing and sales. If anything, Russia’s longer term market access has now been severely constrained by EU’s and US newly found strategic prudence, leaving behind Gerhard Schroeder’s eastern-leaning enthusiasm as little more than a quaint reminder of happier days.

It would have been perfectly possible to negotiate, under international aegis, a workable solution for all parties involved in Ukraine and Crimea. At least in Europe, after decades of trial and error, minorities with strong group identity have today a range of options – as exemplified by the (very different) pathways of the Scots and the Basques. It was not necessary to press the case in just several days with armed militias and their ”locally purchased” assault helicopters. Economically gouged by its deposed mafias, Ukraine now needs friendly assistance to rebuild its statehood. The neighborly betrayal during this crucial period will long be remembered in this part of the world. But by alienating Eastern Europeans further, Mr Putin is in effect strengthening Germany's economic stranglehold on Mitteleuropa - a region that Russian revanchists would dream of controlling again.

Some Russian nationalists hail the arrival of the ‘multi-polar’ world, supposedly ushered through the farcical 'vote' in Crimea. We will continue to love Достоевский, Рахманинов, Лермонтов, Шишкин and your uniquely beautiful language. But, as the UN vote showed, your political and economic ‘pole’ will now be given a wide berth. However graceful your pole dancing may very well be.

Monday, February 24, 2014

Now that pictures have emerged of the opulence which Yanukovich and his cronies enjoyed, the online commentary (often stated in Russian, rather than Ukrainian) asks the hitherto apathetic public opinion of the East and South of the country whether these are the symbols of power they are truly committed to defend. It’s a fair question but not because it appears politically provocative. And here’s why.

I once witnessed a fascinating scene while strolling near the Kremlin. A cavalcade of black limousines sped up at a clip that would make Formula One drivers envious. Only in Colombia had I seen official limos speed that fast, but that was part of the local security routine. Terrorist challenges that Russia faces today are of different nature and kidnapping is not a big business. And yet, the speed with which the convoy wheezed by brought the rulers close up (though impersonal) to the astonished passers-by. At the same time it separated the two groups. For someone who at least once a year has to share the jaded co-denizens’ indignation at Midtown Manhattan’s UN meeting galore – complete with its unpredictable traffic misrules - it was the precisely the quasi-religious reaction of the Muscovites which surprised me. The locals froze, immobilized by sudden awe during the nanosecond-long proximity of power, the fleeting, yet physical communion with the untouchables. Was it Putin himself? Other dignitaries?

A screen full of simulacra separates Russians from the ultimate worldly authority that rises up like iconoclasis in Orthodox tserkovs. The inner sanctum of the mundane and the supra-mundane must be left inaccessible if it’s to be awed. Not surprisingly, Russian rulers have traditionally sought the buttress of devotional sources to shore up their legitimacy and claim for Moscow the title of “Third Rome”, the last pure remnant of the only genuine Christian tradition.

But this vertical societal tradition has clashed repeatedly with Ukrainian history. Ukraine, predominantly rural and, for a long time, only spottily populated outside of the main river valleys has been an offspring of a uniquely egalitarian project. A horizontal society with a selected number of competing rulers who were mostly of external origin: the Ottomans in the South, Polish overlords with their Jewish administrators from the West, finally the Russians from the North. But below those foreign implants, there was a largely horizontal society. With a sense of warrior class superiority, Khmelnitsky’s Cossacks must not have cared much about peasants’ welfare, but they originated from the Ukrainian speaking roots and responded to (and partly formulated) its aspirations much more adequately than any foreign-tongued magnates could. If Russians continue to view Ukrainian urbanites as external to this egalitarian tradition, it may be due to the history of allegiance to the Soviet cause that many Ukrainian (and not only Russian or Jewish) Communists continued to evince even during the height of Holomodor, blaming the starving peasants for their “reactionary attitudes”.

Russians are not Ukraine’s first neighboring nation making this mistake. Having failed (or never seriously attempted) to create a Republic of Three Nations, the Polish-Lithuanian Commonwealth reacted belatedly to the awakening of Ukrainian national psyche. Nearly 300 years after Khmielnitsky, for many Polish nationalists, Ukrainians were little more than peasants speaking with an accent (the two languages are, to some extent, mutually intelligible). As a result, misguided policies in hitherto Austrian-administrated areas of inter-war Poland triggered an even stronger nationalist response from Ukrainian intelligentsia. In its most brutal terrorist/freedom fighting form, OUN’s activists specialized in physical elimination of first Polish and then Soviet targets (anti-Semitism, prevalent among right-wing groups in Europe at that time, was not OUN’s core ideology). But in the dark days of Bloodlands, the cataclysm of ethnic cleansing, which cost between 60’000 and 200’000 civilian Polish lives in Volhynia and Galicia, was but a sideshow of mass murder orgies exercised on a dispassionately comparable, or even larger scale by contemporaneous Germans and Soviets.

Yalta and its repercussions dealt a painful blow to both Ukrainian and Polish patriots. Ukraine lost any hope for independence and Poland was lost to European history for 40 years. In the monochromatic postwar years, many young people continued fighting without much prospect of beating the Soviet yoke. By 1948, armed nationalist groups in the forests of now Communist-dominated Poland were obliterated. But Ukrainian underground UPA (Underground Insurgent Army) operatives continued to inflict painful losses to Soviet administrators well into the 1950s. To this day, older Russians whose relatives were stationed in Western Ukraine recount with dread the years when not even MGB forces could completely pacify the elusive guerrillas.

It’s the eventual crushing of this movement that bestows on the symbols of the 1940s resistance project a strongly anti-Russian message. Alarmingly, some of these emblems have been resurrected by elements allied with the motley crews of the anti-Yanukovich front. A friend has pointed out this week that the insignia of the self-appointed security guards in Kiev are the same as those used by the infamous Galician Division, which fought alongside Nazi forces in mid-1940s. The exploitation of Austrian (Galician) nostalgia for political purposes by the Nazis in Ukraine helped score some extra cannon fodder for the division. But we should not forget that while being useful (and sometimes extremely cruel) pawns in Nazis' hands, these young men tried to safeguard future independence of some rump Ukrainian state, which, by 1944, was threatened more by the Soviets than the Nazis. Whatever their ultimate Lebensraum ambitions, the Nazis did not have time to engineer in Ukraine a devastation comparable to horrors of Holodomor, the mass famine campaign conducted by Stalin and Lazar Kaganovich in the 1930s, still fresh in the shelled out memory of those who lived in the 1940s. The fact that Stalin added Volhynia and Eastern Galicia to Soviet Union after Yalta was a shock to Western Ukrainians. The story goes that when Mikolajczyk, a Polish leader from London, tried to reason with Stalin on the westward border shift ("Lvov has never been Russian"), Stalin answered: "But Warsaw was". Tony Judt once quoted Clement Atlee speaking of Stalin: “no flowery language, only yes or no, but you could only count on him if it was no”.

Putin’s camp realizes full well that the pro-Nazi past of some of the Ukrainian nationalist heritage is an easy target. Just as Latvia learned in its often painful adjustment to Brussels’ left-liberal bidding, Western Europeans do not recognize full equivalence between Nazi and Soviet crimes. The fact that the elites of those countries, along with Finland, viewed Hitler as a counterbalance against Soviet might is poorly understood in Western Europe, for which Soviets were feted as allies against a monstrous and seemingly unstoppable regime. This is where Warsaw’s active involvement in the EU-Kiev equation irks Moscow.

Poland’s unapologetically anti-Nazi credentials during the Second World War are not in dispute and the country has its own dramatic history of conflict with Ukrainian nationalists. And yet, in its determined westward tilt, Poland has long weaned itself of any illusions of direct or indirect involvement over the vast black earth lands to the East. In fact, the Soviet-directed mutual ethnic cleansing after 1945 turned Poland into a largely homogenous society with little folksy variety to speak of. But that colorless homogeneity became an asset in the wake of Communism’s collapse. A multi-ethnic Poland might have faced many a Yugoslav question, had it not been deprived of its Ukrainian minorities by the might of Stalin’s reliable nyet.

Nevertheless, some Russians tend to view the Lakhs’ (Poles’) involvement in broader historical terms of cultural and religious confrontation. If Ukrainians’ group identity is fuzzy, it is precisely because of the patchwork of past Russian, Polish and, to some extent Turkish influences. Far from being a brotherly nation that the most recent of these three former empires claims it to be, Ukraine presents a kaleidoscopic picture of religious and dialectical allegiances – not least because of the history of the last 100 years. Yes, the unassuming Lenin’s statue on one of Kiev’s nicer intersections is now gone, but there still is an imposing statue of Vladimir Ilitch near the seafront promenade in Yalta. Meanwhile, in Lviv, what was once Sapieha Street (a name of a well-known Lithuanian noble) has changed its name 3 times since the war. It first became "Stalin’s street", then "улица Мира" (Peace Street) and now the same street is called Вулиця Бандери (Bandera Street), after the name of a controversial nationalist, executed by KGB in Munich in 1950s. In another town of Western Ukraine, near a local Greek Catholic church, a statue of Pope John Paul II (who spoke decent Ukrainian and visited this country) contrasts, shoulder to shoulder, with UPA allegories.

It is true that Western Ukrainians have been most incensed by Donetsk mafias’ recent economic misrule and large scale racket these networks institutionalized. But the friction goes deeper into the core of mutual identity theft between the Right and Left banks of Dniepr River. The Greek Catholics – whose rituals are eastern, but whose allegiance is to the Vatican, have been in ascendancy since the Independence in 1991 and their HQ is now located in Kiev, not in the West. As a child of Polish-Lithuanian Commonwealth, this church – uniquely Ukrainian – is scorned by the Orthodoxy. But then the playground of Orthodox Christians is divided into three competitors: Autocephalous Church with roots in Western Ukraine (actively persecuted by the Soviets), Kiev Patriarch’s Ukrainian Orthodox Church and, crucially, the Ukrainian Orthodox Church whose allegiance lies with the Moscow Patriarch. The latter’s ungainly inroads into Ukrainian official space during the Yanukovich years will almost certainly cause a backlash now.

Russian Orthodox Church’s role has never been benign when it comes to Ukrainian affairs. Moscow Patriarch became independent of Constantinople in mid-15th century or some five hundred years after Prince of Kiev Volodymyr had converted into Eastern form of Christianity. Forever since the Russian Orthodoxy has misappropriated the symbols of Kievan Rus’s heritage, thus depriving people on the Dniepr of the right to their own past.

What Tsars referred to as “Little Russia” and what Slavic language dubbed as the “Limit” or “Frontier” (Ukraina) flowered with its nationhood aspirations not long after the anti-imperialist awakenings that shocked Austria-Hungary’s multiple ethnic groups during the second half of the 19th century. But these aspirations clashed with Tsarist Russia’s assignment of inter-ethnic issues to practical, and not overtly political, relations. Throughout the 19th century, big parts of today’s Ukraine were actively russified (and, wherever applicable, de-polonized), a process only partly successful. In 1863, Russia introduced “Ukrainian language law”, banning most publications in vernacular. Then it banned imports of Ukrainian literature from Austria-Hungary and elsewhere. Moscow viewed Ukrainian as “Russian language contaminated by Polish”. The fact that the language survived at all owes much to the fact that 20% of ethnic Ukrainians lived in Austria-Hungary and Tsarist diktat could not reach there.

In a particularly sensitive turn in 2012, the Russophone President Yanukovich and his allies rammed home the issue of bilingualism. I remember watching on Ukrainian TV heated debates between agitated proponents of Ukrainian language, crossing semantic swords with much more self-assured Russophone officials from Donetsk or Kharkiv. The debate was perfectly bilingual and fascinating at that. Each side seemed to understand what the other side was saying, but expressed itself in its own language. If it sounds quite a bit like the Swiss Parliament in Berne, it might even smack of self-confident multi-lingualism. But the context of the imposed law, which deprived Ukrainian vernacular of any chance to take root in the Russian-dominated areas and thus undermined the difficult process of solidifying a common national identity should not be lost on the enthusiastic proponents of Schwyzertütsch-emptied civility of Curia Confederationis Helveticae in Berne.

The Yanukovich episode betrays the continuing cultural insecurity that many Russians outside the Russian Federation feel. Yes, it must take some effort to learn Latvian, and especially Estonian. But is this truly such an insurmountable hurdle? Russian is a language of a great literary glory and significant scientific achievements and as such is not an endangered species. Other than post-imperial hiccup, what really stops Russian speakers from embracing a similar, and deeply sonorous lingua? After all, ethnic Poles of Lviv and Crimean Tatars are also mostly bilingual as they have to be in order to survive in the land which is not, at least not yet, a confederation of separate cantons, each with its own education system. Crimea, incidentally, could be a focal point of any such struggle. Not a part of historical (Hetman) Ukraine of the 17th-18th century, it was a Khanate with a Turkic language and an islamicized population. Catherine the Great’s invasion of Crimea in 1783 turned it into a novel slice of Russia, at least until 1950s, when Soviets turned this most visually appealing slice of Black Sea’s northern shore into a part of Ukrainian SSR – a UN member in its own right. Yes, as a Russian-serving imperial domain, USSR made some crass geopolitical mistakes on the way. But then, the exiled Tatars were coming back since 1957 anyway.

This is a big country. A land blighted by grain requisitions of the 1930s, the brutal war campaigns of the 1940s, Stalinist persecution in Western Ukraine, “anti-nationalist” campaigns conducted between 1961-73 and the rule of successive (and mostly Russian-speaking or ethnically Tatar) mafias since the Independence. A nation that is painfully forging, at long last, its own core identity. It needs to cease functioning as a ‘limit’ between Europe, Turkey and Russia. A promotion of its distinct Ukrainian culture - including its political culture will have to be fostered. The protection of linguistic, religious and other minorities will come anyway as it is the inevitable price for the cake that Europe would offer.

One lesson is clear. Left in limbo, Ukraine will lurch from one crisis to another – unreformed because unable to afford the bitter pill of structural adjustments, emaciated by rent-seeking elites salivating at the prospect of yet another round of lucrative energy deals, hollowed by successive mafias aligned with various political groupings. There is little doubt that Yanukovich was a particularly skilled thug at this game and his electoral campaign, created by puppet masters from Madison Avenue was as convincing as it was ultimately successful. But a decade after the Orange Revolution, the country is still waiting for its first positive hero. Not a Bandera, not a Shukhevytch, not even a Khmielnitsky or Mazepa. Not a warrior, but a builder. Let us hope she or he will emerge from this tragic chapter.

Wednesday, September 28, 2011

THE TYRANNY OF OPAQUE MARKETS

By the nature of our profession, we are naturally obsessed by what we see daily on our screens. However, in the last several years I have become fascinated by what we do NOT see there. With so much risk capital now captured by the South and the East, unfortunately for us, the opacity of the dealings will only increase. There are three, interrelated reasons for this:1. East of Istanbul, some 75% of all deals are done in the private market2. The experience of 2008 led to a breach of trust and much higher dependence on stocks, to the detriment of flows3. As a result of this obsession of physical inventory control, coupled with low interest rates, contango has evolved in certain commodities, most durably in some metals

Yet, this realization is relatively new. Some three years I traveled from Charlotte NC, where I worked for a multistrat hedge fund, to New York to listen to a number of UBS strategists and analysts. I do not remember the exact date, but this must have taken place sometime between May 2008 when the commodity equities turned sharply down in London and July 2008 when Hank Paulson’s memorable speech reversed long commodity/short financials trade.

The UBS strategist was quite flippant in his dismissal of the weight represented by the emerging markets. He complained about the pressure on him to learn Mandarin and reassured everyone that the proverbial fatso from Costco would have to save the planet as he or she is ultimately irreplaceable. The argument went like this: America with 300m population consumes 11.5 tr worth of goods and services, whereas Europe with twice as many people consumes half of that figure. Japan is a distant third with $4tr worth of consumption and China, well, not in our lifetime shall we see it carrying the weight of responsibility for global growth.

But even if that UBS strategist spoke with a British accent, his view of global economy was strongly embedded in the “consumption” school of thought. In this view, consumption, or end-demand, is what propels this planet around the sun. But then, the end of the world appeared on our Bloomberg screens. Very slowly did we begin to understand that while consumption does matter, consumption on borrowed dime would eventually end in tears.

So what happened since those momentous events three years ago? Closer to home, we dusted off the Austrians. Today angry Congressmen spit out one-liners from Henry Hazlitt’s adorable paperback and Michelle Bachman carries with her a volume penned by von Mieses on a holiday break. And the rest of us? Well, we are all a notch closer to Schumpeter’s view that the way to expand the economic wealth of a nation is not to: • use fiscal policy and liquidity injections in order to "stimulate demand"• incur huge fiscal and monetary cost to defend holders of bad debt• risk long-term slowdown by obstructing the restructuring of excessive debt burdens

No, from a macro perspective, living standards can be increased only in two, but diametrically different ways:• through capital consumption, i.e. dis-saving and massive borrowing, something we avidly tried (and succeeded) during the Clinton-Bush era, or• through capital accumulation, i.e. savings and capital investment, a model arduously pursued today by many emerging markets.

We all know that the demand for capital dropped among the developed economies, with FAI/GDP falling from 25% to 18%. At the same time, it has grown in the emerging markets. In India it stands at 33% to GDP and in China 47% and STILL growing at 25% yoy. The question remains, of course, how “productive” (from the Schumpeterian perspective) the growth in the East and the South has been. I believe that the picture there is somewhat mixed. The quality of growth in emerging markets has been uneven and with rising current account deficits and rocketing credit intensity of GDP growth (quadrupling fourthfold in China) may have even deteriorated in the last three years,. But the persistent growth differential between “us and them” is undeniable and should correspondingly affect our thinking about the commodity space across asset classes: the physical, the futures and even the equity.

PHYSICAL COMMODITIES

Commodity professionals, we can give themselves credit that, at least since 2003-04, they have been paying a lot of attention to China. Indeed, I am sometimes amused when I hear about China being “over-dependent” on exports. It was back in 2003 that the leadership of the Chinese Communist Party (CCP) began to question a development model based on exports and on co-opting private entrepreneurs into the Party Congress, a process that had flourished in the late 1990s. 2003-04 was also the time when a decade of Zhu Rongji’s financial reforms had already borne fruit, China had become a WTO member and was in a build-up mode for the Olympic coming out party. In order to bolster the position of the state-owned enterprises, a shift from exports to fixed asset investment became a priority.

A decision was taken that the "pillar" industries, including energy, mining, steel manufacturing, automotive industry and telecom would be dominated by companies under government control. Granted, private enterprise was there to stay, but tolerated only as providers of jobs, foreign exchange and technology. In December 2003, PBOC established Central SAFE investments (Huijin), which later helped recapitalize state-owned banks using foreign exchange reserves, thus entrenching a growth model based on state-owned banks offering loans to SOEs and the same banks coming back to the market every couple of years to recapitalize themselves. The ensuing lending binge unleashed a tsunami of construction activity which durably transformed many commodity markets. In response, Sir Bob Wilson, upon his retirement as Executive Chairman of Rio Tinto, cautioned against commodity markets’ excessive dependence on China.

But dependent we became. The observation of overdependence has been particularly glaring in the commodities that China is net short: metallurgical coal, copper, iron ore, oil, platinum group of metals, soybeans.

We are often victims of our own wishful thinking, expecting the world to become somewhat more Anglo-Saxon, more free-market-ish and more democratic in general. Meanwhile, despite the trappings of (our) modernity, the Chinese Communist Party’s model still has a lot more in common with the Soviet system than with ours. Unlike the pre-Gorbachev Soviet system, which tried hard (and eventually failed) to control the flows and volumes of products, components, subcomponents and commodities throughout the value chain, CCP devised a system in which it controls not the widgets, but the supply of economic factors, and consequently their price. As most of us still remember from the economics class, there are three basic economic factors: land, capital and labor. This is how CCP achieves this in a state-controlled economy with Chinese characteristics:• land supply control, through state-ownership and land registry at municipal level (I will return to this later), • capital control, which remains underpriced through capital account controls and distributed through lending quotas, • labor supply control, with the two-tier population registry (hukou) system: the locals and the migrants and the central guidelines for provincial decisions regarding the minimum wage.

This system may be bursting at its seams now, but it is still firmly under CCP’s control, with the possible exception of underground lending.

Now, if you control all the factors, then regardless of your personal make-up (which may be highly technocratic and pragmatic, rather than ideological), you and your organization will develop a Leninist control culture around it and will be pretty upset if there are ANY inputs whose supply you do NOT control.

The iron ore market is a case in point. China Iron Ore and Steel Association (CISA) is a bureaucratic entity mandated to protect the interests of the country’s steelmakers. If you meet CISA’s officials in Beijing and overcome their initial “we won’t tell you ‘cos you’re a foreigner” (我不告诉你，因为你是外国人) you will soon learn that Western governments, (yes, “governments”) have devised a perverse plot to deprive China of access to iron ore resources and thus to strangle its birthright growth rate.

Much has been said about iron ore market’s high Herfindahl index of supply concentration. However, Sir Bob Wilson was not entirely wrong. Today as much as 25% of global seaborne iron ore of about $1bnt p.a. is destined for just one market: long steel products used in Chinese construction. And when asked about how sustainable this is, most analysts point to the continued “urbanization”.

Contrary to the claims of such reductionist commentators, urbanization itself is NOT a market phenomenon, but a process driven by a confluence of institutional decisions in China, whose sustainability depends largely on the durability of the system based on three pillars:1. the Constitution of PRC, which turned all land into the property of the State2. the lopsided structure of provincial budgets, responsible for 77% of expenditure but entitled barely to 46% of federal tax transfers, which turns these budgets dependent on land transfers. As much as 70% of the provincial budget relies on land transfers (leases below cost, sales tax, spec sales). 3. the capacity of local officials to single-handedly transform the value of land by re-allocating land from “rural” (whereby rural land can only accrue value from 30-year leases) to “industrial” or “residential” (where 70-year ‘lease’ is possible).

Urban Development Investment Corporations or UDICs (城市发展投资公司) and other many similar entities (6600 of them nationwide) have been structured to bypass the inability of municipalities to sell bonds directly. The existing products often showcase a glaring mismatch between maturity and revenue generation. However, UDIC bonds (and infrastructure loans) do not have principal payments until years after the communist officials in charge of the province are long gone. Meanwhile, the interest payments are being satisfied with land sale proceeds. Today, the system is saddled with an estimated $RMB11tr (or nearly $2tr) of debt, representing some 42% of China’s GDP. The system’s cheerleaders tend to profess high level of comfort with this number (given the value of assets potentially offsetting this burden), conveniently forgetting that under conditions of uncertainty, the duration of a financial institution’s liabilities shortens and the duration of its assets lengthens.

This process of forced urbanization, embedded in this institutional framework does not affect commodity markets in which China functions as a significant primary producer, e.g. zinc with its global surplus of 256kt this year. But it certainly does matter for iron ore, where the problem is compounded by the dropping exports from India, as illustrated by the recent political and legal wrangle in Karnataka and Orissa. China’s iron ore reserves are of low quality and despite $1bn annual exploration spending, the aggregate reserve depletion is among the fastest on the planet. Looking at the data from US Geological Survey, the 60mt per month importer may run out of domestic sources of iron ore within 9 years.

This is a linear, finite view of the emerging market commodity phenomenon, but cyclicality and seasonality are of equal importance.

SEASONALITY

Since most humans evolve in a climate characterized by regular changes – four seasons in temperate climates, dry and wet seasons in the tropics, near permanent darkness and midnight sun in the Arctic – most of us also come to expect some form of recurrent patterns. Some traditions have even injected such hopes into religious thinking, thus avoiding the eschatological destiny of much of the Western heritage. By the virtue of climate, tradition AND the related credit subcycles, seasonality imposed by the emerging markets has begun to trump such well-respected recurrent references as the US driving season, European winter heating season, US hurricane season or sometimes even northern hemisphere corn planting season. In fact, as we could observe in the last several years, the industrial metal demand dances around the Chinese credit cycle.

The Chinese credit market is directed with an annual, rather than Japanese fiscal or Australian calendar. As the state owned banks have, by government fiat, guaranteed 3% spread loan/savings rate ratio on some $2 trillion worth of savings, they are keen to open their loan books as early as possible after the beginning of the calendar year and earn maximum interest within the official quotas permitted by the regulators for that particular year. Much of that credit goes to builders, contractors and manufacturers. But a lot of this lands with legal, quasi-legal and illegal underground lending system, starting with the commonly tolerated Minjian Jiedai 民间借贷 – or “civil borrowing”, through mutual assistance societies Huzhuhui (互助会), all the way to subterranean loan sharks Gaolidai (高利贷), who would later use this liquidity throughout the year at interest rates we can only remember from Vito Corleone movies.

As a result, the builders are in a position to contract new projects and the commodity import machine is set in motion, with the concomitant impact on the seasonality in China’s current account. Every year, depending on when exactly the Spring Festival falls, sometime between February and April it becomes fashionable for a wave of Western analysts (and some politicians) to express a collective sigh of relief that “Chinese surplus is shrinking and the problem of undervalued renminbi will soon go away”. Consequently, it would be highly improper, impertinent and uncivil of us to dub the Chinese government as a “currency manipulator”. And so it goes. China continues to intervene in forex markets at $1.4bn a day, and Chinese trade surplus is indeed shrinking (from $295bn in 2008 to $183bn last year), but not necessarily in terms of bilateral exchanges with the US as our soybeans exports (even coupled this year with our corn exports) prove insufficient to quench Chinese thirst for inputs, much of which remains very seasonal.

NO PERPETUM MOBILE

The law of structural dynamics means that every self-reinforcing loop will eventually encounter sufficient constraints to slow down the process. Such constraints are already present in the Chinese economy. Robert Mundell was right. If you do not want to realign your prices in relative terms through exchange rate, you will sooner or later pay for this with real price adjustment. This is exactly what happened in China with 87% increase in M2 over the last three years. It is now frequently quoted that this is a country with a third of US GDP and a monetary mass 30% higher than the US. I find it intriguing to compare China of today not with the US of today, but with the Nixon era. The 1970s show how long the lag could be between the M2 avalanche and the onset of inflation.

However, too many of us get carried away by this obsession with inflation and commodities. Not even gold, a financial product par excellence, is perfectly correlated with inflation. Others argue that the value of gold is simply a mirror image of the trade-weighted dollar, but this conveniently dismisses the fact that most other currencies are also losing their purchasing power, not in terms of CPI-related indexes, but in terms of their capacity to acquire assets. As real buying of gold occurs also outside of the USD currency zones, gold represents a useful yardstick of value for all of those currencies, not just the dollar.

No, where gold truly reacts against the extremes, it is in terms of how we connect future and present prices. And we do it via interest rates, in real terms. Gold perfoms well when the expectations become entrenched that real yields will crawl in the gutter for a while. The main exception is the period 1994-95, marked by a Greenspan interest rate hike that panicked the bond market.

FUTURES

Let us move now to the impact on the futures market. Here too, the institutional framework in the emerging markets, and particularly in China is actively shaping the global marketplace.

A critical juncture came in 2008, when the ultra-capital intensive system designed by the Chinese Communist Party and described above was severely tested and then further enhanced. Half a decade into the fixed asset investment binge that made China a linchpin for all the commodity markets with the exception of oil, the 800 pound gorilla trader was still sitting on a 19th trading infrastructure. As China slowly integrated into the world economy, the letter of credit (LOC) system remained key element in its dealings with overseas trade partners. The growth was extraordinary. By 2007, almost 70% of China’s exports were financed with LOCs. But on the import side, so vital for supplying China with raw materials, letters of credit were practically the only avenue for trade financing. It is understandable (at least for sinologists) that pre-payment schemes are not very “Chinese” culturally speaking, but Beijing failed to develop alternatives to the LOC system, which are necessary to keep the trade flowing during periods of credit stress. Factoring could have been one way to deal with the issue. It is astounding that in an economy of 1.3 billion people, the Chinese government issued only two import factoring licenses over the 30 years of reforms.

As many remember, the sudden collapse of China’s LOC system in late 2008 led to a catastrophic slump in most commodity prices. One day I could be sitting with a CFO of a mid-size Australian iron ore company, who professed his confidence in the future, and the next day his panamax vessels were floating idly in Southwest Pacific in search of a willing customer. What did this lesson mean for the buyers? Do not trust the flows, trust only the stocks. So a quarter of a century after the Just in Time system thinned out the value chains, upstream commodity business went in the opposite direction as if we were all in perpetual preparation for a war or, at the very least, for a collision with a large asteroid. China’s Strategic Reserve Bureau began its frenetic buying spree: becoming the world's top importer of copper, soybeans, iron ore, cotton and natural rubber and among the largest buyers of coal, vegetable oil, sugar and potash. Importantly, this hoarding behavior coincided with record low interest rates globally, and it was no different in China.

Two years into the great credit-lubricated party, inflation expectations had become so pervasive that multiple increases in reserve requirement ratios proved insufficient to cool the economy. In October 2010 China officially entered the “tightening mode”. On that day, commodities blipped, but nobody remembers that. By the second hike in December 2010, the commodity market shrugged it off completely. Although some argue that any increase in domestic interest rate exposes its central bank to sterilization losses, the PBOC is not really an independent policy bank. Rather, it is a ministry subjected to the decisions of the State Council, where so-called “stability” is paramount and the commercial considerations secondary. Yet this is a ‘stability’ where food price inflation is in double digits and rents in Beijing shoot up 100% yoy. Someone got scared and the screw had to be tightened.

For the rest of us, the story that has unfolded since then is one of copper.

In January this year a friend announced to me: “this year I am going to short gold and go long copper”. I asked ‘why would you do that?’. Well, “gold is a bubble, but copper has real demand, Chinese really buy it”. I asked: do you know what they do with this when they buy it? He was not interested: “supply and demand”.

In fact, all we usually know about demand in China is the so-called “apparent demand”, i.e. production plus net imports plus/minus changes in Shanghai exchange stocks. When in 2009, Chinese net imports rocketed from 1.360 million to 3.112 million tonnes, it was hard not to see the hidden hand of hoarders: legitimate commercial restocking, strategic moves by SRB, and speculative stockpiling. Conversely, strong end-use and low apparent demand in 2010 pointed to destocking.

By comparison, what has happened since the tightening of interest rates at the end of 2010? Since then, Chinese copper importers have become… bankers. Unfortunately for my buddy the investor, they did not import copper to consume it. And the difference matters. They exploited the system to obtain – and provide - renminbi.

With new official loans in the first five months of this year falling 12% to 3.55 trillion renminbi ($549 billion), it was only a matter of time till the loophole was filled with typically Chinese ingenuity. Already in 2010, letters of credit issued by Hong Kong-listed Chinese banks jumped 70 percent, faster than the nation’s overall trade growth of about 25 percent.

It is useful to review the cat and mouse game between the importers and the regulators and to see what the impact on copper market has been, especially in Asia.

Companies could apply for a 90-day or a six-month dollar-denominated letter of credit to import refined copper, but not really to consume it. The only price was a requirement to put down 20 percent of the value of the imports as a deposit to the bank for the LOCs.

First, copper was imported into China by speculative investors for resale in China. They would sell the metal domestically once it arrived and lend out the earned (renminbi) cash at higher (unofficial) rates before repaying the letter of credit at maturity.

However, because Chinese copper prices have maintained discounts (up to nearly $200/t) to the London Metal Exchange prices since 2010, it forced the speculators to put contracted imports into bonded warehouses, most of which are located in Shanghai area. By March 2011 this shadow stockpile reached a reported 1mt. From here on, there were two ways to obtain renminbi. Investors could either:1. use the bonded inventory to borrow collateralized loans at 90% or even 100% of the stored material and most frequently re-lend this capital at higher interest rates, or2. re-export the copper.

Why would re-exports be of interest to investors? First, remember that in an economy with the closed capital account, exporters have to exchange their dollar inflows into renminbi. Secondly, following some successful lobbying by importers, the regulators scrapped the rule whereby these stocks had to pay 17% VAT in order to be re-exported.

However, last April, the Chinese authorities tightened rules on repatriating foreign currency from re-exports. Now, the Chinese firms were required to leave such foreign currency earnings in pending accounts and were not allowed to convert them into renminbi until they received receipts of import payments and re-export incomes. Financial intermediaries also had to cut their advance payments from foreign importers and delayed payments to exporters to 20 percent of the total foreign exchange they sold or bought over the past year. That naturally affected all those who carried several outstanding letters of credit at the same time. But the demand for renminbi credit continued to outstrip the official lending quotas and the cat-and-mouse game continued. Enter offshore renminbi. To much fanfare, some 20 months ago Beijing had opened up Hong Kong as an offshore venue for investors willing to gain access to renminbi-denominated assets, allowing foreign companies and banks to raise funds in Chinese currency for cross-border trade and investment. Some 67,000 Chinese companies were allowed to participate in the offshore renminbi business. Now, investors trying to resell their bonded copper overseas began to ask foreign buyers to settle trades in the “offshore” renminbi (CNH), remitted from offshore banks in Hong Kong. This summer, however, PBOC moved to tighten the screws on offshore trading and notice No. 145 stressed that the onshore market had not been liberalized and the capital account remained closed. Widespread CNH selling has intensified since and continues to date (late September 2011).

More importantly for the copper market, it soon became possible to deliver the material from the bonded warehouses against Shanghai Futures Exchange contracts. Previously, imports were subject to VAT payments in advance of the delivery against exchange contracts. There are two consequences of this change. First, it removed one hurdle to trading the arbitrage between the Shanghai bourse and the London Metal Exchange. Secondly, in case backwardation appeared in Shanghai, you could now deliver physical against it. For futures traders it could be a way for the shorts to cover their exposure, instead of buying back shorts. The outcome would be reduced volatility.

What does this opening mean for the copper curve? A copper-collateralized loan costs an importer 6 to 8 percent, but the renminbi obtained this way is then re-lent in the “underground” market at rates 3x that much! What is the significance of this? It’s an alchemist’s dream. We turn copper into gold.

One of the reasons why the cost of borrowing base metals, such as copper were generally higher than prevailing interest rates (i.e. µHowever, as long as µ>λ there is an implied rate of return (interest rate less lending rate) on holding the metal. Gold usually provided such an implied rate of return, but base metals did not. Global gold inventory does not matter because the metal is plentiful. In fact, this is how Indian jewelers finance their gold inventory, through gold lease rates, thus avoiding currency risk. And even though gold lease rates generally have a negative correlation with spot prices, the calculated base rates do not ultimately matter.

Gold may have been in contango since Lucy left Olduvai Gorge, but in the case of Chinese copper, if 民间借贷 or 互助会 interest rates remain above the LOC interest rates, then we end up with gold-like characteristics:

Not surprisingly, contango appeared in Shanghai despite all we know about the tightness of copper concentrate, labor activism in Chile, winters in Atacama desert, strikes at Grasberg, low TC/RCs and high merchant premia. This contango would be here to stay, if the futures market in Shanghai was not so jittery about the maze of potential regulatory changes concerning:• LOCs deposit, interest rates and associated currency exchanges• offshore renminbi repatriation• bonded warehouse taxing

Indeed, State Administration of Foreign Exchange has introduced rules to make it harder to use the metal as collateral and in late August People’s Bank of China required banks to place a part of the original collateral held against LOC in low yielding reserve accounts, instead of using it to make further loans. That means that it is going to become more expensive to issue the LOC.

Interestingly enough, the dearth of renminbi credit led not only Chinese investors and merchants to use dollar-denominated LOCs. Even Chinese producers of semi-finished copper products have begun to use letters of credit to purchase USD-priced bonded copper in Shanghai, rather than in the CNY-denominated spot market, for which they do not have cash. Bonded metal in Shanghai can be delivered to buyers in two days after stock owners pay the VAT. Banks in Jiangsu and Zhejiang have been advised not to issue LOCs to purchase bonded copper from Shanghai warehouses, arguing that these only applied to imports and not to the metal already stored in the country. But local banks would continue to provide credits if their bonded copper purchases are resold in the domestic market, rather than re-exported.

Assuming the symmetry in terms of CNY/USD preference, the above pyramid build on copper (or soybeans, or any other) collateral could potentially crumble the moment capital flees towards USD, as it is commonly the case during the episodes of global liquidity stress. This could explain some of the vicious Chinese selling of metals (including copper) throughout most of last week. But more ominous signs could be just around the corner. There are reports of letters of credit refused for imports. The sensitivity of Chinese trade to global credit woes has not diminished.

FINAL WORD

It is time we abandoned the dream that global markets, including financial markets, will somehow lead to homogenization of the world exchanges. Capital and goods move freely precisely BECAUSE of differences between localities, their institutions and their cultures. It’s Asia’s fears that drive its demand for gold, its quest for liquidity and fresh credit or the taste for the control of the physical inventory.

At a conference in Oxford 10 days ago someone was stunned that a decade of global growth delivered a zero return in the US stock market. I find this tunnel vision baffling. It is irrational to expect that Asians would put their wealth in pension funds which, in turn, will efficiently allocate capital to underpriced US stocks. What do we know about their economic behavior, obsession with land ownership, real asset control, inter-generational wealth transfers, seasonal consumption patterns and underground lending structures indicates that commodities, thanks to their fungibility, still remain the best bet we have in the public markets to participate somehow in the waves triggered by China’s and India’s fears.

Monday, June 21, 2010

Time has come now for some musings about this tournament… It is bound to be relatively uncontroversial, and, mind you, it is coming from far afar from any reputable soccer-lands.

My first grown-up decision was not to watch the game with the ubiquitous Irish accent this year. Instead, I am watching “la copa del mundo” led by the inimitable Fernando Fiore and a crew including, among others, the unforgettable Paraguayan goalkeeper Chilavert. Granted, he is no Gunter Netzer, but at least his analysis of goalkeepers’ work is worth its every Guarani-accented syllable.

As much as the initial 16 matches infused me with deep disappointment over the quality of the game (and I am not spoiled by the Champions League – unavailable here unless you pay extra for ESPN), the mid-point is bringing some more constructive thoughts.

I will not dwell here on the quality of the referee work. I think we all agree that a Mali guy permitting Greek-Roman wrestling during Slovenia-USA game and then annulling a US goal to expiate himself was out of his bald-headed depth. A Guatemalan dude whose main job was to be impressed by World Champions’ captain and offer a PK against New Zealand should have his eyes gouged by flightless birds. Allowing Luis Fabiano to score while helping himself with his arm must have occurred only to a guy in awe to his own wet dreams about Gerson and Tostao. And sending off Klose against Serbia was somewhat light-headed, to say the least. But nothing beats referees’ deference to guys who find face-magnets in their fingers. This is how a French referee was conned into sending off Kaka, and a day later another referee sent off Switzerland’s Behrami (whose arms should have been flying a little less ‘free style’, given Kaka’s experience a couple of hours before). These decisions are a disgrace. Does FIFA really have to enlist Mali, Guatemalan and Frogland referees just to make it “international” ? I fear the day when a game is adjudicated by a man from Somaliland.

So let’s get back to the game now.

It was supposed to be Africa’s World Cup. The only true authorities about the beautiful game, such as the revered sports magazines in the United States, had proudly proclaimed that the tournament prefigured “The Rise of the African Soccer”. For anyone who traveled around Africa, this bold statement would have come as a little surprising. Soccer needs not only talent, but also capital, local follow-up system, organization, corruption-limiting third party oversight and a ticket-paying fan base. None of this exists even in the most successful countries of West Africa. To top it all, the highest FIFA-ranking African team has not even qualified for this World Cup (Egypt, starring a new player by the well auguring name: Zidan). The result? Africa is 1-4-7 after the initial games and chances are that not even Ghana will qualify for the next round. Ghana may be the best organized of all the African squads, and the author of the continent’s single win thus far, but even Gyan & Co have trouble with finishing touches and score only on PKs. The only other positive surprises from the host continent were individual – such as Algeria’s stout Boughera or Ivory Coast’s tireless Gervinho.

Yet, the haplessness of Afrikan football is mindboggling. From South Africa’s :”ticky-ticky”, through Etoo’s unbelievable disappearance in the hands (feet?) of Japan’s Nagatomo, to Nigeria’s utter emotionalism (and self-inflicted red cards), all the way to Ivory Coast’s ueber-hard tackle – this tournament is anything but Africa’s. Send your boys to Europe and forget about bringing them back, you losers.

Next in line comes Asia. Despite plucky Japan’s and South Korea’s initial wins, the tiny players somehow can’t rise to the next level. Surely, these two sides have potential, but it never comes anywhere near the high-league level. Australia’s move to Asia’s football association deprived Uzbekistan (or is it Iran?) of the even more pathetic showing. Then, there is Kim Jong Il and his tearful squad stuffed by Japanese-born ethnic Koreans. The fact that they chose to play for the red star team (rather than for South Korea, or Japan) tells us more about Japan’s (and UN’s) problem with sanction-breaking ‘Chosen Soren’ in Osaka, than about the quality of North Korean soccer. Add to this a bunch of Chinese “fans” for whom Kim Jong Il’s regime bought tickets to cheer on the untravelled national side and you have the result. Portugal’s 7:0 comes close to the 1974 records of Yugoslavia-Zaire and Poland-Haiti. Good riddance to the North Korean military. I wonder what they are going to do now? Commit ritual suicide? Defect? Go back to toil on potato fields? The fantastic forward Jong Tae-se will probably go back to being Japan League’s top striker. The commie dream is over. The (real) Asians stand at 2-0-4.

Then we have the (non-European) Anglo-Saxons. This time Australia has disappointed, and the US – always an unknown quality to heavyweights – is yet to clinch the qualification. But the nicest, most unspeakably thrilling surprise came from New Zealand – the only country (next to North Korea) without any professional league. The fact that they could notch 2 points in just as many games is a great testimony to the mates’ dedication to this game. The Anglo-Sax group stands at 0-5-1.

Next comes Eastern Europe. Despite all the oligarch money, Guus Hiddink’s Russia did not make it here. This bodes poorly for the likes of China (or India) which may try to buy their way into future world cups. Instead, we have Slovenia – which is leading its group, the ever-unpredictable Serbia cheered on by fascist-clad fans whose military caps are somehow allowed into the allegedly post-racial South Africa, the dejecting Slovaks and the drab-as-usual Greeks (I know, they were not part of the Eastern Bloc, but they are Orthodox, further east than anything else in Europe and their soccer is the dullest of all). Despite the fact that the best team from this part of the world (Croatia) is not here, the group is actually outperforming the expectations, with 3-2-3. I suspect the 1/8s will be as far as they go. Or have you seen a Stoichkov, or a Hagi, or a Lato? I have not.

This brings us closer to the source of all the moans. Western Europe. With a tally 7-5-6, the score of unfulfilled expectations is brimming. But I guess these sides are firming up. Two of them have a real problem, though. One is France. Bringing to South Africa suspected pedophiles was a bad idea. It now turns out that they (led by their token white bloke – Ribery) terrorize the rest of the squad. Most non-French believe that the team should not be in South Africa in the first place, given Henry’s hand-driven goal against Ireland. Aren’t the French stars apt at destroying their own legacy with last minute outbursts? (think Zidane). In any case, the Afro-French team has a real problem – its coach has lost control. Three pieces of advice. Leave criminals at home. Get a coach who does not understand French (insults addressed to him by Anelka or Malouda). Try to score with any part of your body, except your hands and family jewels.

The next on the list of troubled nations is less surprising in this tournament – the perennial underachiever (and inventor of excuses for its underachievements) - England. A couple of weeks ago, at a European airport, I spotted a British tabloid asking with big titles – “who is the best player in the world: Messi or Rooney”. I beg your pardon? I never knew I would enjoy the British sense of humor that much. What a delicately skewed pique!!! Masterful. By the way, seen Rooney in the last two matches? In a more serious British newspaper this week, a gum-in-chin comment reads: “plucky England holds off mighty US and almost wins against Algeria”. Apt indeed.

Next would be Italy. Here, at least, you can give them some credit. Yes, their penalty area theatrics is risibly passé. Yes, they have the custom of starting out in a rusty manner. And yes, New Zealand are a formidable foe (sorry, I needed three reasons, it’s the style thing). But it is true – spaghetti soccer oldies do not even have a single top 10 world star in the line-up. Doesn’t it make their expectations a little lower this year? I guess so.

Then there are the statisticians. They looked at Spain and concluded that no team ever became a world champion after losing the opening game. And only Germany followed up on the European Championship with the world crown two years later (1972-74). Ergo, Spain is out. Not quite. True, Iniesta is failing and Torres in poor form. But there are countless inferior teams around. The real trouble for Spain and for the soccer spectacle is that the diagonal Barca-style has been deciphered not only by Mourinho’s Inter, but also by Swiss coach Hitzfeld, and possibly by many others (though not Honduras). The side is not infallible. Shame about the timing.

Germany had the only impressive opening among the first 16 games. The Polish-born fronting duo, supported by a new Turkish star in the middle and a young Tommy Mueller seemed to get it all right. Then, reduced to play with one man down, die Mannschaft revealed the weakness in its substitutes. Germany could always boast the depth of its squad. If not Netzer, then Bonhof. If not Voeller, then Bierhoff. If not Ballack, then Ozil. But, in turn, Ozil, Podolski and Klose are hard to replace. Marin has been given blinkers against low-hanging South African sun and thus finds it hard to believe there are any teammates raound, Cacau rams single-mindedly through the middle and Mauro Gomez hardly gets anything spherical in his vicinity. Joachim Low has spent some time cracking Ghana. My bet is that Germany will send the only decent African team home. But later?

Then we have Holland. Star-studded and famed to be the next best thing after gouda (and Cruyff), the side came here to reclaim its rightful place. The Dutch are soccer mad (though, apparently, Norwegians are madder). My partners in Amsterdam seem to have stopped working 10 days ago. And the results are coming (not in terms of the company’s performance, but in soccer terms). But results only. I do not know if this is down to Robben’s absence, or the dehydrating altitude in Joburg, or the fact that Afrikaans does not conjugate Dutch verbs, but the van Pierse/Sneijder side has been the shadow of its own expectations. And the back does not seem to support the movement as in the eras of Krol, Koeman or de Boer. We want more. Begrijp je me?

Portugal? Still hard to judge them after the second half against North Korea turned into training practice. There is potential here, with Cristiano Ronaldo taking Deco’s directing role with some bravado. But can they beat Chile or Spain?

Of the less fancied teams, both Denmark and Switzerland have a chance. Denmark needs to knock out Japan. Tough, but not impossible. Switzerland needs a high score against Honduras. The Swiss side are the authors of the biggest sensation of the first round and they boast Diego Benaglio – probably the best goalkeeper of this tournament (this is, in any case, Jose Chilavert’s view).

All this brings us to what we quietly expected from a tournament taking place outside Europe. In 70 years, never did a European team win World Cup outside what Norman Davies calls a “Penninsula” – an appendage to Asian landmass. Due to Africa’s meltdown (or rather freeze-up, given the glacial age temperatures in Joburg), the responsibility to edge out Euro-trash teams falls, once again, on Latinos. And indeed, the first 32 games produced an impressive result – 9-2-2, with the two defeats by Honduras (one in the hands of another Latin American team).

There is a lot to celebrate here. Mexicans finally came with a full-control game against the Afro-French disarray. Paraguay almost plucked away Italy. Chile has a consistency and great talent, if not always the finishing execution. From this list, the most impressive is possibly Uruguay. Forlan’s incredible footwork, rat-sneeze shot and midfield command make him into one of the grandest figures of this tournaments so far. Uruguay produces a memorable player every decade: Mazurkiewicz, Francescoli, Recoba. Forlan could yet be the best of them all if he can fully count on the team’s support.

Which leaves us with the two contrasting sides: the touch’n’pass Argentina and the long-cross-ball Brazil. Argentina shocked die Zuschauer back in March, when they beat soporific Germany 1:0. Still nobody cared. After all, a cocaine addict runs the team, so what’s the big deal? But can anyone stop Messi’s uebermenschlich footwork? Hardly. Maybe, by taking the ball from Mascherano, so that it never gets to Messi.

This should be Brazil’s plan. After all, the two are bound to meet in the semi-final and then one of them will head to a final game that could oppose either of these teams against Germany or Holland. Dunga’s team is more like Dunga-the-captain’s team of 1994. Not once since Paolo Rossi trounced the Falcao/Zico/Socrates magicians, did Brazil again try to play for the sake of beauty only. The way Maicon broke through North Korean (Chinese?) wall was the apex of the unexpected. The way soccer should be. Brazil does seem to be a little messy, it breaks the rhythm, it does not dance. But it finds imaginative ways into the net, eventually. That counts. And you have to add to it Gilberto Silva’s astounding long crosses (I always thought Philipp Lahm was the best human in this department, but now he has competition).

The spectacle is improving. We had some spectacular goals – Tschabalala’s (RSA) against Mexico in the opening game. Heintze’s (Arg) header against Nigeria. Park Ji Sung’s (S.Korea) bolt netting against Greece, Forlan’s (Uruguay) first against RSA. Macoin’s acute angle shot into North Korea; two similar rockets – by L.Donovan (US) against Slovenia and by Luis Fabiano (Brazil) against Ivory Coast. But Podolski (Germany), Gerrard (England), Birla (Slovenia), Vera (Paraguay), Tiago (Portugal) and Villa (Spain) also showed flashy and effective execution.

Tuesday, December 30, 2008

For those of us who have made through it, 2008 might well be remembered for personal successes and achievements, but collectively it has certainly set the world back, at the very least in terms of its wealth, health, environment, security and stability. With the possible exception of scientific progress, the faith in linear historical developments has now been duly, albeit belatedly shattered.

This surely makes us wiser. Yet, by itself, this is not a reason to gloat. As Vernon Sanders Law once quipped: "Experience is a hard teacher because she gives the test first, the lesson afterward". And so, let us bid farewell to 2008 without nostalgic sobs. We may in future remember it as those inexplicably 'hard' teachers from schools. In other words, we will remember 2008 better than other years.

Below are THREE LISTS of various events which occurred in 2008 and, deservedly or not, may linger in our memory. I begin with (rather obvious) negative headlines. This is followed by my own very personal view of what was positive throughout 2008. The third list focuses on the absurdities whose copious supply the passing year ensured regardless of the latitude, longitude and season.

The following TWO LISTS shift emphasis to the uncertainty surrounding the upcoming 365 days. I first review the risks of varying impact and probability of occurrence. Finally, to end on a perhaps naively positive note, I outline my wishes for 2009. They range from perfectly possible to nonsensically dreamlike. But then, the beauty of these times is that we are still free to dream. And to blog freely about it.

2008 - THE GOOD:1. Obama won !!!!!2. After 13 years on the run, Radovan Karadzic is caught in Belgrade3. Ingrid Betancourt freed in Colombia shortly after Bogota hobbled FARC’s operational capability in Ecuador4. Iraq’s (tentative) improvements in State building5. Some Olympic glory (mostly Jamaican and in the fish-swimming events)6. Pervez Musharraf bows out in Pakistan7. Doha compromise averts further bloodshed in Lebanon8. Constitutional crisis in Turkey avoided when the Court rejects a call to ban AKP9. Kosovo declared independent10. The Dalai Lama meets with Bush and with Sarkozy11. The President of Sudan Omar al-Bashir indicted by the International Criminal Court12. John McCain’s concession speech13.The founding of COPE promises the creation a viable (?) opposition in South Africa14. The Pope blasts pedophile priests during his trip to the US15. Liberia’s Charles Taylor is put on trial at the Special Court for Sierra Leone and Rwanda’s Theoneste Bagosora is condemned to life imprisonment by the International Criminal Court for Rwanda16. Gordon Brown thrives in crisis: not a bad performance at all…17. After 40 years, Spain wins Euro soccer18. Relative peace in the Taiwan Straits19. Nambu, Kobayashi and Masukawa receive Nobel Prize in physics for their work on asymmetry20. Particle accelerators at CERN are now ready to tell us more about it all…

THE ABSURDITIES OF 2008 (almost funny, except, they were true):1. Private jets bring CEO beggars from Detroit to Capitol Hill2. Greenspan spits it out: “I was wrong”3. From London to Paris to Seoul, the Olympic torch “tour” of shame4. “President” Dmitry Medvedev learns to walk5. Sarah Palin’s family (was it Piper, Steeler, Rodder and Plater?) can see far from their window6. Carla Bruni-Sarkozy mania towers over her husband’s high heels7. Chinese sports fans “forgive” athlete star Liu Xiang for his failure to run 110m hurdle heat8. Russian war games in the Caribbean (oh, phleeeze!)9. Hillary Clinton’s tears in New Hampshire save her campaign (for a while). Then the poor woman suffers from Bosnian amnesia, probably caused by sniper fire.10. Two Russian sumo wrestlers are banned for life by Japan’s Sumo Association for smoking marijuana. What were they thinking? That it would help them regain slim looks?11. Joe the Plumber almost wins the US presidential ‘debate’, but in the process he inadvertently turns the 1.5% Americans who make $250’000 or more, into a “middle class”12. Eureka! Eggheads at National Bureau of Economic Research take a year to recognize that US economy has been in recession.13. Chinese children pose as ‘adults’ in gymnastic events (not enough baby formula perhaps?)14. Forecasters’ demise. At the beginning of the year, Goldman Sachs made its 12-month predictions: crude oil at $105 per barrel (it is $38/b), natural gas near $11/mmbtu (it is $5.8), gold falling to $750/oz (instead it went up to $869/oz), Korean Won at 900 to the dollar (it is at 1260)…and the Fed Funds rates were supposed to be at 4% (it’s 0.25%)…15. 40 years after USSR, China sends a manned rocket for a space walk16. Helicopter Ben in action. US prints $7.6 trillion in bailout money during the first 11 months of the year. The combined debt is now apparently at $67 trillion.17. Hugo Chavez sings on TV (and then sends troops to the border with Colombia)18. It snows, so China can’t go on holiday. The Olympics is over, but China forgets to come back from the holiday.19. Nearly thirteen centuries after Vikings established the first Russian state, Russia offers to “buy” Iceland (like you buy an aircraft carrier)20. Rudi Giuliani’s presidential “campaign” founders in Miami. Thumbs down, but no one is thrown to the alligators. 21. North Korean nuclear “negotiations”: now you see it, now you don’t22. Castro dynasty holds on in Cuba (sign of change: people are allowed to buy cellphones)23. Hollywood strike saddens the nation, but somehow no one rushes with handouts24. Education in action. Kindergarten kids in California are asked to pledge never to use anti-LGBT (lesbian, gay, bisexual and transgender) slurs…25. At the peak of the market in June, famed pundits from Jim Rogers to Don Coxe hail commodity investments and launch new products. But they are young enough to be in it “for the long run”.26. Mr McCain goes to Washington (to save us from the economic crisis). We are relieved.27. Silvio Berlusconi is back (no grey hair here)28. John Edwards’ campaign-financed lovemaking fails to ruffle his hairstyle29. Having scrapped onboard service, punctuality and courtesy, some US airlines now charge for checked-in luggage, a cup of tea and a glass of water. Lavatory use and pillows will be next.30. Russia recognizes South Ossetia as “independent”. North Ossetia remains ‘part of Russia’.31. Paulson’s summertime tale: ‘sorry, children, no shorting allowed now’32. Anglican Church faces a schism. The world holds its breath.33. Food fascism invades US schools: a child in Connecticut is suspended for buying a candy bar34. Oprah Winfrey can’t lose weight and Madonna lives sexless life for six long months…35. Surprise: O.J. Simpson is a bad man. No SUV chases this time due to political incorrectness of the vehicle.

2009 - THE RISKS:1. The world plunges into global deflation, hobbling both the deleveraging private sector and the re-leveraging public sector. Oil hits $20 per barrel.2. Competitive currency devaluations3. Social instability in China redirects the regime to nationalist adventurism abroad4. Hillary Clinton derails Obama’s agenda5. Al Qaeda’s operatives in Algeria and Morocco mount a terrorist offensive in Europe6. Iran gets the Bomb7. Israel strikes Iran. Iran retaliates. US navy presence in Hormuz strengthens radicals in Tehran.8. Impoverishment in China triggers another wave of Avian flu9. Financial deleveraging and precautionary hoarding of capital continues apace10. Czech Republic’s Vaclav Klaus chairs EU and derails whatever European cooperation there still is11. Benjamin Netanyahu wins elections in Israel but depends on Mosche Feiglin’s support12. Felipe Calderon loses the war on drugs in Mexico13. Obama’s administration taxes capital, and in a chilling reminder of the 1930 Smooth-Hawley act moves to “protect American jobs” from international competition. 14. Trade financing collapses, leaving strained value chains and empty shelves15. Hamas does what Hezbollah did in 2006, i.e. strengthens radicals after another Israeli military failure16. In the wake of the above, Egypt falls into chaos, fuelled by Muslim Brotherhood’s radicalization. Amr Khaled’s televangelism loses audience.17. Major Internet glitch18. Al Qaeda wins control in the tribal areas of Pakistan19. Zulus and Xhosas resort to violent means in the fight for political spoils and sinecures in South Africa20. India intervenes against ‘terrorist camps’ in Pakistan21. Russia cuts off gas to Ukraine and Europe22. From US to France to Slovakia to Russia, global automotive industry dies out, rising jobless rates by millions23. Collapse of $54 trillion market in credit default swaps24. Global protectionism kicks in (no trade financing, non-tariff barriers, NAFTA moribund, WTO defanged)25. Global capital expenditure fails to respond to stimulus. Lack of upstream investment lays the foundations for future hyperinflation.26. Peer Steinbruck wins elections in Germany and allows Russia to reclaim proxy influence in the Baltic Countries27. Canada disintegrates28. Bolivia fractures in a violent manner. Santa Cruz struggles to have its independence recognized internationally.29. Failure to reform “mark-to-market” rules further undermines confidence in the market30. The Dalai Lama dies, opening the way to overt (and bloody) independence struggle in Tibet31. Kim Jong Il dies and leaves unstable vacuum of power in North Korea32. Western military intervention in Darfur fails33. Warren Buffett proves to be yet another scam…34. Populist politicking in US kills a proposal to declare a holiday on payroll tax35. Cash-strapped local governments raise taxes, offsetting national stimuli…36. Kosovar mafia and Salvadorian maras shake transatlantic hands after yet another year of rising crime rates

2009 - HOPES AND WISHES:1. Osama bin Laden and Ayman Al-Zawahiri are captured and tried for their crimes2. Major breakthrough in combating cancer (through stem cell research?)3. International financial and economic cooperation is made possible under Obama/Volcker leadership. Counterparty confidence returns and usable collateral reappears in the market. Interbank funding conditions improve.4. Nicolas Hayek’s companies in Jura accelerate successful commercialization of a fast electric car5. Low sunspot activity delays climate change and helps extend glaciers6. A public exchange for credit derivatives is inaugurated with success7. Russia runs out of foreign reserves due to its ill-conceived defense of the ruble in the environment of low oil prices. Brave Russians bring the end to the decade of Putinism.8. Governor Bobby Jindal rises to lead the Republicans. The influence of social conservatives marginalized.9. Mohammad Khatami runs against Mahmoud Ahmadinejad in Iranian elections and wins10. Zhang Qingli, Secretary of Communist Party of China in Tibet is put on trial at the International Criminal Court11. The Fed prints even more dollars and when the bond yields rocket, it buys them back, keeping interest rates low and transferring the wealth from creditors to debtors. In the process, inflation cuts down the debt burden and a weakening dollar radically reduces the value of foreign reserves accumulated during the preceding decade thanks to the mercantilist policies of oil producers and China. 12. Gold protects investors exposed to weakening dollar13. Global airline industry consolidates into a binary market: low cost and high-end, killing hapless US airlines (and ‘rude hostess’ jobs) in the process14. The Amazon forest conservation system brings first territorial gains in Brazil. Indonesian officials are invited to study the progress.15. Dick Cheney, former Vice-President of the United States is accused of, and tried for maintaining links with Halliburton while in public office in 200316. In a breakthrough initiative, US induces Israel to abandon illegal settlements in the West Bank. A viable Palestinian state is made possible. 17. Israel gives back Golan Heights. Syria becomes a US ally.18. EU boosts its defense capabilities and cooperation with NATO, with positive impact on the military engagement in Afghanistan and Darfur19. Further development of the global market in liquefied natural gas (LNG) and EU investments in Central Asia begin to wean Europe of its dependence on Gazprom20. Further opening of arable land to cross-border investment in agriculture21. Governments revitalize corporate credit markets22. Taiwanese hi-tech companies revolutionize touch screen technology, ushering in a new era in notebook development23. After international navy forces squash the pirates, the former Somalia is officially divided into three states (Somaliland, Somalia, Puntland) in an international conference which also solves Maakhir and Northland issues24. Germany, Brazil, India and Japan become permanent members of the UN Security Council and begin to reform the organization25. A modern, multiracial bi-party system is born in South Africa, with COPE building a strong opposition to ANC. Cyril Ramaphosa returns to politics.26. Supported by international forces, Kinshasa finally cracks down on Interehamwe’s forces. Rwanda’s security is safeguarded and Laurent Nkunda neutralized.27. Robert Mugabe dies. Structured international assistance helps Zimbabweans rebuild their country28. Belarus opens up to the West and sucks in investment, offering high rates of return29. A new technology is developed to denitrify waters contaminated by overferilization30. Commodity prices stabilize. Saudi Arabia manages to protect the markets from high volatility in oil prices.31. Serbia swaps the Kosovo emotionalism for EU membership. Hardline nationalists marginalized.32. Venezuela’s Chavismo turns less rhetorically virulent and more pragmatic, avoiding clashes with Obama’s administration33. Beijing redirects defense, navy and 'star wars' funds to education and health care reform 34. Music sharing via internet remains free35. FARC signs an unconditional peace agreement in Bogota. End to decades-long civil war opens up Colombia to investment and tourism.36. End to the Yushchenko/Tymoshenko political feud in Ukraine helps stabilize the economy37. Greek government chills out: less anti-Macedonian rhetoric, more labor market reforms38. Guinea (Conakry) escapes violence in its transition to democracy39. Good monsoon relieves pressure on agricultural economies of South Asia40. A post for an infrastructure Czar is created in the White House, helping to channel stimulus funds without subcommittee filibuster41. US and Germany regulators abandon plans to destabilize the “banking secret” rules in Switzerland42. A power-sharing deal ends the political stalemate in Thailand43. Guantanamo Bay detention centers closed44. With little export dependence and much interest rate firepower, Indonesia joins Brazil to emerge as the most defensive emerging market anchor for global investment45. Roger Federer beats Pete Sampras’s grand slam record46. Due to rising populations, polar bears, tigers, snow leopards, black rhinos and Iberian lynxes are taken off the endangered species list47. China and Iran abolish death penalty48. Justice and peace in Burma, Xinjiang, Kashmir, Pakistan, Darfur, Afghanistan, Kurdistan, Kivu, Palestine, Abkhazia, Ossetia, Chechnya, Niger Delta, Ogaden, Eritrea, Cote d’Ivoire, Sri Lanka, Northern Uganda, Michoacan, Mindanao, Dagestan, Fiji, PNG’s Highlands, Bougainville, Tibet, Mauritania, Southern Thailand, Crimea, Nagorno Karabakh, Corse and the Basque Country.49. Atlantis is re-discovered. Religious zealots and fundamentalists of Evangelical, Sunni, Shiite, Judaist and Hindutva ilk are all relocated to live there in their own, pure way.

Sunday, December 7, 2008

Over the last several weeks, the focus of the market has shifted from ‘financial crisis’ to ‘global economic crisis’. The surplus savings economies that were supposed to bail us all out have exposed structural weaknesses of their own. For years, the petro-economies and mercantilist Asia plunked their savings in the supposed safety of US Treasuries. This investment inertia has not only led to the relative atrophy of these immature economies’ own capital markets (as a percentage of their GDP), but also crippled any development of their risk management capabilities. If the investment in US Treasuries was, by definition, riskless, then why bother assessing uncertainty of other investments? Risk aversion and paucity of other investment options have now resulted in a new bubble –in cash (mostly US dollar and the Yen) and in US Treasuries, which, at the time of writing yield barely 2.56% on a 10-year note.

When the fabled sovereign wealth funds and other pools of capital were eventually deployed into the Western assets in the late 2007, the subsequent losses proved to be politically unacceptable. Not surprisingly, the massive reserves accumulated by mercantilist China will now most likely be deployed to re-nationalize domestic assets where personal connections allow for building trust networks, an age-old bulwark against risk.

The unfortunate corollary of this collapse in trust is that it not only prevents any rebalancing between the external surplus economies and the external deficit economies, but that it could lead to the collapse of the trading system as we have known it.

GLOBAL TRADE THROTTLES BACKSince early in this decade, the global trade flourished even if no new trade liberalization round has been achieved. The integration of China into WTO in 2001 was a major step boosting the trade flows. After the move to re-industrialize its economy (2003-2004), China’s trade links to other emerging markets allowed many smaller economies to flourish. On a net basis, the losers were small textile producers. The winners were commodity exporters.

The commodity imports were, next to craved foreign technology, the only form of large scale imports condoned by China’s mercantilist rulers. Instead of growing internal demand and a balance external accounts, China developed an economic system favoring massive exports based, as it was commonly believed, on cheap labor and undervalued currency. But there was a third factor in this extraordinary export boom. For centuries, China’s economy stagnated because of trust deficiency outside of family networks. The clans were broad-based and often spread their merchant tentacles around island South-East Asia. But further out, in the wild, threatening world of non-kin, plagued by greed and exploitation, you could only purchase something if you paid for this up front. Now, this is exactly what most of us do in Carrefours, Walmarts and Ito Yokados if we decide not to pay with a credit card. But it is different in long distance, long term trade. The British excelled early on in global trade networks because of extraordinary expansion of a reliable merchant credit and credit insurance system. Letters of credit (LOC) were introduced by the banking system to facilitate the flow of goods and ensure the eventual payment.

As China slowly integrated into the world economy, the letter of credit system appeared also in its dealings with overseas trade partners. Buyers’ banks would issue an LOC to the seller, whose own bank would subsequently discount it. The growth was extraordinary. By 2007, almost 70% of China’s exports were financed with LOCs, leaving a smaller percentage to government-led insurance discounting, as well as traditional up-front payments and down payments. Two-point factoring, another form of international trade financing did not expand as fast in China as this system may easily fall victim to a fraud.

On the import side, so vital for supplying China with raw materials, letters of credit were practically the only avenue for trade financing. It is in the current collapse of China’s LOC system that we should see the roots of the devastating, deeply deflationary, catastrophic slump in most commodity prices. It is devastating and catastrophic because unknown in its depth and extension, or so we hear from Australia’s largest company whose ships full of bulk materials float aimlessly in search of an eventual buyer.

Throughout China’s boom years, Beijing failed to develop alternatives to the LOC system, which are necessary to keep the trade flowing during periods of credit stress. Factoring could have been one way to deal with the issue. It is astounding that in an economy of 1.3 billion people, the Chinese government issued only two import factoring licenses over the last 30 years. Even worse - the lack of proper reform of the credit system in China means that exporters into China cannot properly assess credit worthiness of the buyers. 30 years since the opening of China’s economy there still is NO proper credit system in place which would allow you to track information about the buyers, regulate disputes and collect insurance! You do not know who you deal with through proper credit assessment (and risk assessment). You ‘know’ it by holding lengthy, MSG-sprinkled dinners in one of Chinese restaurants. We are back to the limited circle of trust, and away from the modern, albeit never infallible, credit system.

This stunning revelation is coming to our attention only now, when Chinese importers default on ‘long-term’ contracts or disappear into the thin air. Chinese banks are equally fearful of discounting letters of credit for the country’s exporters. This is risk management in the form of risk aversion. Chinese banks do not trust their counterparties overseas, fearing massive bank failures and complicated recourse procedures. Although fear has gripped many corners of the global credit market since September, no single trade financing institution has collapsed as yet. Chinese banks’ risk aversion is, therefore, a self-fulfilling prophecy leading to the ultimate collapse of the trade links. Only yesterday did we hear that the world’s largest container producer, based in Shenzhen, had stopped production since October due to lack of demand. And although it should be expected that the government intervenes in export promotion through more wide-ranging use of insurance discounting, for now many Chinese exporters require up-front payments from overseas importers, which is highly damaging to these partners’ working capital. At a time when equity and credit markets send a deflationary signal that “cash is king”, parting with your current assets to secure imports is a finite solution at best. And after that? Empty shelves at Walmart?

EMPTY LECTURINGAll the hopes that the global crisis will concentrate the minds around a global solution have now been dashed. Mr Wang Qishan and Mr Medvedev are barking at Washington, faulting the US economy’s recession not only for their fast evaporating riches, but also for undermining the very basis of their power, this implicit pact with the local populations that a quest for freedoms is but a secondary, and easily dismissed footnote under the universal desire to live in opulence. Russia’s rapid impoverishment is unprecedented. Within only two months the country which last summer postured with military swagger has lost a staggering $123bn of reserves trying to shore up the rouble, an effort eventually abandoned. China’s growl is even more ominous. Beijing angered EU by executing an Austrian citizen’s father for allegedly ‘spying for Taiwan’ (read: revealing secrets about Chinese leaders’ health). In a huff, China has now also called off a high level summit with European Union after President Sarkozy agreed to meet with the Dalai Lama. Beijing had recently rejected Tibetan envoys’ proposals for regional autonomy (which is enshrined in PRC’s constitution). Yes, the Communists intend to run Tibet’s allegedly ‘Autonomous Region’ directly from Beijing, in a blatant breach of their own constitution. But the economic collapse and 70m unemployed Chinese workers (and counting) are clearly making Beijing fearful, increasingly angry and paranoiac. The country has cornered itself into overdependence on US Treasuries’ performance, but this is only the latest bubble of many that formed over the last 15 years. Since the dollar bottomed in mid-July, yields on 10 year Treasuries have fallen 21%. This is exactly equivalent to gain in US dollar index. This rally, and an even stronger appreciation in the Yen would mean that the world bracing for a deep deflation. Yet, at the same time, in dollar terms, gold has lost only 21% since that mid-July anchor. This means that the yellow has stayed flat in constant dollars. And gold-buying is a sign of inflationary insurance further down the line, which could be brutal when the velocity of money picks up again and the Fed will rue the extraordinary expansion of its balance sheet from $100bn in September to $750bn sixty days later…

FROM DEEP DEFLATION TO SHARP INFLATION?The thesis of a very sharp inflation following the impending deflationary spiral is increasingly being hushed about. Someone calculated that, at $7.5 trillion of new bailout money, a stack of $1000 bills would build a tower 760 miles high….

Meanwhile no concomitant expansion has taken place in gold, or indeed in other commodities. There is no doubt in my mind that dollar-denominated assets will again, as they did in the late 1970s, overshoot on the upside, powered not only by this extraordinary expansion in liquidity, but also by the unprecedented contraction in capital expenditure and new project development. The combined effects of collapsing demand, declining corporate profits and surging corporate bond spreads leads not only to shutdown of marginal production, but to outright destruction of future productive capacity. Already, OPEC is warning that the current oil prices are discouraging investment into new capacity. As the Russian oil production ebbs away from the next year on, significant capacity constraints may hit again in the upcycle, even before the global transportation eventually weans itself of its overdependence on diesel, gasoline, jet fuel and bunker fuel. In the mining industry, an estimated $200bn worth of capital expenditure has been taken off the table for the next 4 years. Essentially, the miners are telling China: “you do not want our stuff? Well, you won’t get it when you need it”. Mothballed projects, closed smelters, silent refineries, cold blast furnaces and idle berths do not augur well for the global economy in 2009. But when the tide turns, there will not be enough “stuff” to satisfy the reinvigorated global demand. The investment cycle has been quick to drop to near-zero levels. It will eventually come back, but with a lag. And when it does, brace for mass inflation and high interest rates. But in the meantime, pity Greek shippers.

So are we all going for a long vacation, nesting at home with a new Wii? Maybe not. There are pockets of capital and pockets of activity. Very few people made money in the highly volatile 2008. But there are those whose activity was never too fond of cycles and volatility. Family estates and private operators will pick up listed assets on the cheap. Cash-heavy Japanese trading companies will expand again just as their more market-sensitive competitors need to protect their balance sheets and shrink their portfolios. Drug cartels will thrive in the economic slump and benefit from increased crime rates. What was boring and unexciting in the boom may turn out to be highly rewarding and promising in the slump. And whoever can properly time a ‘long oil, short US Treasury’ trade will be celebrated as the brightest man on the planet.

IT’S NOT ONLY THE ECONOMY, STUPIDBut there is also a danger. A danger of such a deep socio-economic dislocation that the world re-emerging from this recession could be radically different from the world of allegedly benign ‘global imbalances’. Thai middle class’s anti-democratic street activism could set a dangerous precedent whereby privileged elites fail to take responsibility for the welfare, education and social advancement of other social groups which happen to share the confines of the same international borders. This indifference and latent antagonism, common to many fast growing economies, may, in economic slump, turn into open hostility. It could pit city vs countryside, as it does in Thailand. But it could pit religion vs religion. Majority vs ethnic minority. Nationals vs foreigners. Our nation vs that wicked neighbor. Scapegoating could easily gain traction among vast numbers of unemployed, young and increasingly angry males. And if they do not have enough money to get married or to pay for sex, their anger may boil over. Watch out for skilled demagogues harnessing that frustrated energy.

Fault-finding, angry talk and competitive currency depreciations by Moscow and Beijing will not help resolve this crisis. Rebalancing global demand patterns, on the other hand, would. There are, alas, no global institutions that could constitute a suitable forum for such a solution. Integrating the superficially capitalist economies into the global trade and investment network worked wonders in the boom. It can pin us down to the bottom in the recession. This morning we received data on China’s electricity production. It fell 7% year on year. China is really shrinking. The world should shudder.